Thursday, July 30, 2009

My last blog post on high frequency trading got a surprisingly wide reception – and was reprinted for several different audiences.The comments at Talking Points Memo were muted and did not touch the general angst about this issue.That is not surprising – that is a politics driven audience.The commentary at Business Insider was outright hostile with the general consensus being that I am an idiot.The reception on my own blog was balanced – with several people pointing out mistakes I made (and I made a few) and with most talking about the argument on its merits.

Still – one lesson – if you write an article that is not outright critical of Wall Street practice then you should expect to be called an idiot.I got endless emails asserting my stupidity.

All I wanted to really understand what the risks Goldman is taking to make all those trading profits.Sure I know most of them are fixed income – but the balance sheet is still in the trillion dollar range and this crisis has proved that ultimately these balance sheets get socialised.If taxpayers are ultimately on the hook then it is incumbent on taxpayers (at a minimum) to understand and manage the risks that they are taking through their regulatory agencies.

Anyway back to the hot-button issue which is electronic and high frequency trading.

First – let’s discuss front running.

I gave an example of a stock that was bid $129.50, sell $131.50.I bid $129.55 and immediately a computer bid $129.60 over me.I called this front running.

I stand corrected – if someone (even proprietary traders associated with my own broker) bids $129.60 over my bid of $129.55 they are not committing the crime of “front running” – but using the public information in my bid to make a different bid.

It would only be front running if they (a) worked for my broker and (b) organised to have their bid filled preferentially at $129.55.

Of course from my perspective it makes not a rats difference whether they got in front of me at $129.55 or $129.56.That difference is less than 0.01 percent and if you are in my business (strict fundamental investing for medium and long term) it makes no sense to be worried about that sort of percentage.Front running as a crime might have mattered when notional spreads were wide and we did not have 1c pricing.But now the issue is just pricing over me and my clients - not whether those orders are legal or otherwise.

The issue is not front-running per-se (except maybe using my broader – non-criminal use of the term).The issue is that more often than not, as a smallish institution, we are forced to go to the middle of the spread or often cross the spread to get filled.Traders – whether they be bots or the old fashioned screen addicted traders of yore make a good proportion of their profits simply by consistently earning spreads.One old Sydney Futures Exchange trader (open outcry) admitted that (unsurprisingly) was how he made his living.Traders make profits on their short term positions (and sometimes make surprisingly good returns on equity).Those profits come out of somewhere – and I am not averse to the notion that Bronte and its clients pay a small share of them.I am not averse to the notion that clever algorithmic traders effectively “tax” other market participants (and I am not particularly scared of that loaded word “tax”).

Nonetheless the tax is small and the issue is not and should not be a target for major reform.The attention played in the blogosphere – driven in part by Zero Hedge – is simply not warranted.

To quantify: these days the spreads are often 1c on $15 shares (say 0.07 percent) and I can easily get brokerage at a tenth of a percent.I can often buy more than enough stock at the high end of spreads.Even if I lose to the algorithmic traders every time (and I accept that I do a fair bit) then – hey – I am paying 0.15 percent for trading.That is a lot better than it was in the old days when brokerage fees were fixed, large and non-negotiable.

Moreover as a fundamental driven investor the turnover in my portfolio is low.Ideally we will turn over less than once per three years – but as market volatility is high we seem to be getting more opportunities for good switches than that.I can’t imagine how the switching costs for Bronte Capital’s portfolio are higher than they were before brokerage reform even with the “tax” that high frequency traders impose on the rest of the market.[Likewise we trade currency with spreads of 1 point (ie down to the hundredth of a US cent).Only a few years ago we traded with 5 points of spread.]

This issue is – as I suggested – a distraction.There are plenty of real issues for financial reform – and one of the most important in my view being the large and seemingly wholesale funded balance sheets of investment banks.Nobody really understands these balance sheets but ultimately we (though the tax base) are guaranteeing them.That is what the slogan “no more Lehmans” means.

Can we focus where it matters?HFT remains a distraction.

John

PS. Thomas Peterffy pointed out in the comments to my last post that fairly good algorithmic trading is available to small institutions like Bronte at very low fees.(He should know – he is probably the single most important driving force behind electronic trading globally.However he is selling his own service.)If anything these programs reduce the “tax” paid by ordinary institutions such as Bronte even further.Peterffy thinks his algorithm tends to beat the electronic traders.We have not experimented enough to back that conclusion.

PPS. A reasonable summary is that old-fashioned traders earnt big spreads with quite a deal of sweat and only a modest degree of certainty. New fangled high frequency traders earn small spreads with high frequency and ruthless efficiency. But they are still smaller spreads.

Friday, July 24, 2009

There are a few changes to this post in italics. These come from the comments.

Goldman Sachs made 5.7 billion dollars of trading revenue in the last quarter.That run rate (over 22 billion per annum) is almost as much as the pre-crisis peak.

$22 billion per annum is roughly $200 per year per household in the United States.

If it is someone’s trading revenue it presumably comes out of someone else’s pocket so measuring it per household is appropriate.

The trading revenue of “Wall Street” major investment banks (including Barclays, the trading parts of Citibank and similar entities) peaked at over $500 per household in the Western world.

Revenue like this is usually paid for a service.Ultimately I thought the service was intermediation between savers in China, Japan and the Middle East (who want Treasuries) and dis-savers in the Anglo countries (who want to fund exotic credit card debt and mortgages).That remains the only service that looks large enough to justify that sort of revenue.[The real service having been finding suckers such as municipalities and insurance companies to hold the toxic waste such as CDO squared resecuritisation paper.]

That said, given almost nobody knows how to make $22 billion per annum trading and jealousy is a common trait, conspiracy theories abound.The current conspiracy theory is that this money comes from front-running clients in the market with very rapid trading.The New York Times recently promoted this view.

The idea is that by knowing client orders you can extract profits.Computers fleece clients by forcing clients to pay more when they buy and to receive less when they sell.

And it is clear this happens.We trade electronically at our fund.We were recently trading in a stock with a large spread.I have changed the numbers so as not to identify the stock – but the ratios are about right.The bid was about 129.50, offer was about 131.50.We did not want to cross the spread – so when we bid for the stock we bid $129.55.Within a second a computer (possibly at our own broker but it makes no difference which broker) bid $129.60 for a few hundred shares.We fiddled for a while changing our bid and watching the bot change theirs.We would have loved to think we were frustrating the computer – but alas it was just a machine – and we were people up late at night

Actually obtaining the stock required that we paid up – and when we did so it was probably a computer that sold the stock to us.

Inevitably we cross spreads and the computer earns spreads.

The computers make even more consistent profits with high volume low spread stocks.If you are buying or selling Citigroup it is almost certain that when you buy you will pay the offer price and when you sell you will receive the bid price.They are only 1 cent different – but in almost all cases it will be a computer that traded with you – and the computer will – through owning the “order flow” be getting the better end of that deal.

That said – these profits can’t add up to sufficient to explain Goldman’s trading profit.Interactive Brokers is (by far) the most electronic and lowest cost broking platform in the world.We use it extensively as do many others.Interactive Brokers has a 12 percent market share in option market making globally and probably a 10 percent share in all market making.Trading revenue was about 220 million.Moreover in the conference call the CEO/Founder (Thomas Peterffy) thought the influx of competition in the area had reduced market maker margins very substantially.

Anyway if 10 percent of global stock volume provides 220 million dollars revenue per quarter then there is no way that a substantial proportion of Goldman’s trading profit can come from high frequency trading.The numbers do not work.

When the New York Times quotes William Donaldson (a former CEO of the New York Stock Exchange) as that high frequency trading “is where all the money is getting made” they are quoting bunk – and they should know it.

This is a plea.Can we have a dispassionate and accurate view of where the (vast) trading profits of Wall Street in general (and Goldman Sachs in particular) come from?The last big boom in trading profits was followed by a bust which came at huge social costs.[Look what happened to Lehman.]

We cannot understand the risks “Wall Street” is taking and hence the economic downside if it all turns pear shaped, and the appropriate regulatory structure, unless we know what is happening.

Mindless articles such as the recent New York Times one – grossly inconsistent with facts are less than helpful.They are distracting.

One comment thought that this was algorithmic trading - someone really wanting to buy the stock - and bidding above our bid when we showed our bid. I wish that were true. If it were then if we were buying very illiquid wide spread things the bot would still be there. It is always there - even when buying defaulted debt that trades once per month. We simply ALWAYS find the bot.

Warren Buffett may – at least in part to make management comfortable – state regularly that his favourite holding period for a stock is forever. And he is a darn good buyer of shares. His name is used to promote "buy and hold".

In 2001 – and almost without comment – he sold a huge stake in Citigroup he obtained by buying convertible notes in Salomon Brothers in the 1980s. You can find no reference to his sale in the letter – but the Citigroup convertible is in the 2000 annual and there is no reference to it in the 2001 annual. He simply converted and sold. He certainly did not advertise the fact - whereas most financial market guys would be boasting that they scored the all time high price.

The profits locked in were huge.

Buffett invested a very large proportion of Berkshire in financial shares. When the bust came he owned American Express, Wells Fargo and M&T Bank. These look like ex-post winners.

Why am I writing today? Because Warren is selling his stake in the Moodys rating agency. It looks like he is rather late. The franchise has already been seriously impaired. Moodys gave its blessed AAA to lots of things that defaulted. Indeed it seems the Moodys AAA is cursed.

Still plenty of people think that there will be a role for rating agencies - and that Moodys end position - backed by regulation - is solid.

Be warned. Buffett is a very canny buyer of equities. He is even more canny a seller.

Monday, July 20, 2009

I have not been a fan of the SEC – but on preliminary evidence I am forming a better opinion of Mary Schapiro than most. However as a tag-end of an era of grotesque incompetence the SEC has had the charges of insider trading it pushed against Mark Cuban thrown out of court.

The charges of insider trading against Mark Cuban were always stupid. I blogged about those charges here. I noted the (public) evidence was only that the CEO of a cash strapped company (Mamma.com) had phoned him and told him that he was cash strapped. Mark Cuban sold his shares. The SEC charged him with insider trading but did not present any evidence that he was an insider. I noted that:

To make him an insider he needs to have agreed to be an insider. He needs to have agreed with the CEO that he will take information confidentially. In other words the case hinges almost entirely on the contents of a phone call between the CEO of a failing dot.com and Mark Cuban – and the call is meant to have taken place in 2004. Nobody is going to credibly remember it. If it came to a criminal charge (which required absence of reasonable doubt) then you would have to acquit Cuban because at best this case will be two people saying “he said” and the other saying “no I did not” about a conversation years ago. As far as I know there is nothing in writing in which Mark Cuban agrees to be an insider (though something in writing is what is required). It is telling that there was no criminal charge filed with the civil charge. The criminal charge wouldn’t fly.

Well guess what – the Judge said that the SEC did not provide evidence that Mark Cuban had agreed to accept the information in confidence and hence did not provide evidence that he was an insider.

And that was obvious from the start. Unless the SEC had something in writing (which they did not) they were stuffed in this case and incompetent in bringing it.

The real issue now is how the SEC got this bad? I spot serious frauds at the rate of better than one per month – and they are rarely prosecuted. Madoff sat in front of the SEC’s face for years. However the SEC went on a wild-goose-chase against Mark Cuban on a case that was flimsy from a distance of 9000 miles (Atlanta to Sydney).

Getting trust in the financial system back is critical to economic recovery. With the SEC so far off its game that will be difficult. Mary Schapiro appears to be doing better than her predecessor. One day I hope to be blogging on SEC successes.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.